Engagement letter fairness opinion fee language may affect fees' taxation.

• Author: Van Leuven, Mary

Language used in investment banker (IB) engagement letters to implement fee payment arrangements can significantly affect the federal income tax treatment of such payments. However, advance planning regarding drafting may result in more favorable tax treatment. This item discusses the governing tax rules at issue, highlights relevant IB engagement letter language, and recommends principles to consider when drafting such language.

As an historical matter, IBs advising on acquisition transactions charged for their services with a success-based fee model. A company engaging an IB for transaction-related services generally would not pay a fee for the services unless the company consummated a transaction. Generally, the amount paid for such services constituted a percentage of the value of the consummated transaction.

Following the 2007-2008 financial crisis, engagement letters began to reflect the IB's intention to recover some costs, regardless of whether the clients ultimately consummated a transaction. For example, in addition to a transaction fee (due at closing), post-2008 IB engagement letters often require a fee upon the occurrence of a specific event other than the closing. This fee is often a fairness opinion fee (FO fee) to be paid to the IB when it issues a fairness opinion. The engagement letter language describing the FO fee is often ambiguous as to whether the parties intend the FO fee to be a milestone payment or compensation for the fairness opinion. As discussed below, clearer drafting regarding this intent may help a taxpayer obtain more favorable tax treatment of the FO fee.

Applicable Rules

Regs. Sec. 1.263(a)-5 (the transaction cost regulations) generally require a taxpayer to capitalize, rather than deduct under Sec. 162 or amortize under Sec. 195, costs incurred to investigate or otherwise pursue a variety of corporate transactions (capital transactions). Capital transactions include a taxable or tax-free acquisition of stock or assets of another corporation (or acquisitions of or from the taxpayer), Sec. 355 distributions, borrowings, recapitalizations, and stock issuances. (For more on this topic, see Witner and Casten, "Tax Consequences of Transaction Costs," p. 394.)

The transaction cost regulations provide exceptions to the general rule requiring a taxpayer to capitalize costs to facilitate a capital transaction. Most significantly for purposes of this discussion, the transaction cost regulations provide a broad exception for certain costs incurred in connection with certain acquisitive transactions (covered transactions). The taxpayer (whether the acquirer or the target) may expense or amortize rather than capitalize those costs.

The transaction cost regulations generally...